Options for public

debt management

Dr Dimitris Sotiropoulos

The Open University Business School

Sovereign debt overhang

Source: Ameco database

Decomposing the big picture

All variables are ratios to GDP:

s: primary surplus

r: real effective interest rate

corresponding to the already-

accumulated debt

γ: the growth rate of real GDP

Δd: the change in the public debt

sf: the stock-flow adjustments

Δh: the change of the monetary

base

hsfdr

sd

1

fiscal

consolidationgrowth in

relation to

debt servicing

inflation

increase of sovereign debt

A simple illustration

dr

sd

10 min

A hypothetical economy:

• with sovereign debt at the level of 100% of GDP (d=1),

• anticipated real growth 2% (γ=0.02; this is definitely optimistic for the short

term), and,

• a real effective interest rate 3% (r=0.03),

• must have as a long-term target primary surpluses of 1% as a share of GDP

(s=0.01) to avoid any further increase of sovereign debt (without any change

in the monetary base causing inflation).

The financial aspect of sovereign debt

• Sovereign debt is a financial asset.

• Financial markets price these securities, quantifying the anticipated results of

future fiscal policies.

• Every quantification is also a representation of economic/social/political events.

• (Small) Countries with weak currencies have very little room to resist market

supervision/disciplining and develop independent fiscal and social policies.

• (Big) Countries or monetary unions with strong currencies have the power to

interfere with market supervision, that’s why they translate the moral hazard into

a political issue.

The limitations

1. Deflationary fiscal adjustment cannot reduce a high sovereign debt.

2. Persistent primary surpluses and/or privatizations are self-defeating strategies;

historical evidence shows that it is very hard to sustain for a long time.

3. Future growth prospects are not so optimistic.

4. Dilemma: unorthodox/unconventional solutions of public debt

management or prolonged austerity and retreat of the welfare state.

5. In the wake of 2008 global financial crisis, unconventional monetary policies

became standard and seem to be permanent (quasi-debt management; negative

policy rates).

Central bank balance sheets

Source: BIS calculations

Central bank balance sheets

Source: BIS calculations

Central bank balance sheets

Source: BIS calculations

An illustration

Eurozone

economies

European

Central

Bank

Moment 1: The ECB acquires and capitalizes in the form of zero-coupon bonds :(i)

debt maturing in the years 2016–2020 and (ii) all interest payments of the same

period (approximately this amounts to 55% of outstanding debt for an average

country). In other words, the debt burden will be suspended for five years.

Moment 2: Each Eurozone country agrees to buy back from the ECB the zero-

coupon bonds when their values will have been reduced to 20% of GDP, jointly

accepting a (nominal) discounting rate of 1%.

Sui generis

long put option

An illustration

1. No debt forgiveness; no direct fiscal transfers and no additional tax

burden for any EA economy.

2. Capital gains and seigniorage profits but also sterilization costs.

3. The overall cost of the program is lower than the ordinary actions of the

ECB.

4. A rising number of mainstream economists and advisors have started

talking about the elephant in the room: central banks (ECB); good timing for

a proposal like this one.

An illustration

Scenario 0: austerity

Scenario 1: capitalization of

debt maturing within the

next five years and related

interest payments

Scenario 2: capitalization of

debt maturing within the

next five years and all

interest payments

Scenario 0: austerity

Scenario 1: capitalization of

debt maturing within the

next five years and related

interest payments

Scenario 2: capitalization of

debt maturing within the

next five years and all

interest payments

Conclusion

Karl Polanyi, 1886-1964

• Polanyi, K. (1944) The Great Transformation,

Beacon Press.

• During the turbulent 1920s, governments had to

intervene to support a failing international

order. They thus established policy mechanisms,

which could potentially be used for different

aims under proper democratic control.

• The policy responses to the crisis have shown

the firepower of central banks. Perhaps it is time

to start the debate of how we could utilize them

for wider economic and social aims.